Question

25. A creditor is willing to offer you $5,000 today in the form of a pure discount loan, an interest only loan, or an amortizing loan. Each loan is for an 8 year period where you will pay interest one time per year (if applicable). While you are willing to pay the creditor annual interest, you do not want to return any of the $5,000 in principle for 8 years. You would also prefer to pay as little interest over the lifetime of the loan as possible. The best loan (s) for you to choose (if any) would be the:

1. The pure discount loan

2. The interest only loan

3. The amortizing loan

4. None of the loans satisfy your constraints

5. Any of loans would work as they are all for the same amount of money

Answer 1

Answer:

Correct answer is:

The amortizing loan

Explanation:

As you would prefer to pay as little interest over the lifetime of the loan as possible, amortizing loan is the best option.

In case of amortizing loan, each installment comprises of both components of Interest and repayment of principal. During initial period, interest component is higher and repayment component is lower. But over time since there are repayment of principal in every installment, the interest component goes on reducing and repayment component goes on decreasing.

Total interest payment over lifetime of loan is lowest in amortizing loan as compared to the pure discount loan or the interest only loan.

Interest only loan pays only interest every year and principal amount is paid at the end of loan period. As such total interest payment over lifetime of loan will be higher than that of amortizing loan.

Pure discount loan will have total interest plus principal payment made at the end of loan period. This will involve payment of interest on interest also due to compounding. As such in case of pure discount loan total interest payment over lifetime of loan will be highest as compared to amortizing loan and Interest only loan.

As such option C is correct and other options A, B, D and E are incorrect.